What is the relationship between yields, risk, rents and price/value in property?

Yields have many different meanings in finance – yield to maturity, running yield, dividend yield, interest yield – and in property finance, the case is very similar. We can talk about initial yield, equivalent yield, reversionary yield etc. It is, therefore, really easy to get lost in a “yield” conversation, unless you stop the other person and ask: “which yield?!”

If you are emotionally intelligent enough (and I bet you are if you are reading this!), you won’t do this so blatantly. So, let’s break down this “yield” conversation first to ascertain the relationship between yields, risk etc.

First, it is safe to assume that “yield” refers to initial yield (at least most of the time I asked the “which yield” question, that was the answer). Otherwise, people would have said “equivalent yield”, “reversionary yield” and so on.

Second, we need to know that the initial yield is the year one return, in other words, the income in the form of passing rent as a percentage of the price you paid or the estimated market value. In a mathematical form:

Initial Yield = Passing Rent / Estimated Value or Price

Very simplistically, if an office building is being sold for £5 million and the passing rent is £500,000 p.a., the initial yield is £500,000 / 5,000,000 or 10%.

Now you can ask yourself: is 10% too high? Too low? Is £5 million too much for this property? Or should it be less? Or more?

It will depend on the property, of course. But mainly, on location, tenant and lease length. If this property was located in the London’s West End, you can say that it is a bargain, since office yields are on average 3.5% in Mayfair (according to Colliers). That means that if the property had a rent income of £500,000, you’d expect to pay around £14 million (500k / 3.5% = 14 m) instead of £5 million. West End is considered a low-risk sub-market because it has strong demand (everyone wants to be there) and limited supply (you can only build new stock if you demolish something first).

Higher demand = higher rent

Now let us imagine you have one building (size, specification) and you can put it in two places with similar amenities (close to the tube station, Starbucks nearby etc). However, one such place is in the West End and other, the City of London. Where do you think you will get more rent from? You will be right if you said West End. Why? Because the relationship demand psf vs supply psf is greater in the West End than in the City, so rents are higher in the former.

London West End Office Rent is £118 psf p.a., whereas London City Office Rent is £70 psf p.a.

As rent is a function of supply and demand, from the prices alone, we can infer that West End office property has a greater relative demand than City office property. Growth, in both markets, is similar and negative (-6% to -7%); at this moment, they cancel each other out.

If we say that the demand is stronger for the West End, we will immediately think that this market is less risky, because the likelihood of finding tenants is higher than in the City.

Also, if the rent drops by £5 in the West End, this would mean a decline of around 4.3% (£5/£118) in the rent, whereas a rent drop by £5 in the City would mean a decline of around 7.1% (£5/£70). Thus, the impact of a £5 rent drop in the City is greater than in the West End.

Now, how does risk translate into property price?

Higher risk, higher yield?

Normally (in financial theory, we call it ‘rationally’), you require a higher return for a riskier investment. Translating the risk into price, you say that you will pay less for the City office property on a per square foot basis because a) you will receive less rent; and b) it is riskier.

Thus, higher risk, higher yield, lower price

In fact, Colliers London Offices Snapshot Report as of January 2018 (below), gives an average of prime yield in West End (Mayfair / St James) of 3.5%, whereas City (core) is 4.0%. It means that West End has lower yield because it has less risk (more demand, less supply, same growth) than the City.

Now back to the equation, you can find the Price or Value per square foot as:

City value per square foot (Value City)

4% = 70/Value City

Value City= 70 / 4%

= £1,750 psf

West End value per square foot (Value West End)

3.5% = 118/Value West End

Value West End = 70 / 3.5%

= £3,371 psf

Summarising:

Higher rents mean a market where demand is high comparatively to other similar sub-markets (we compared West End and the City of London)

Higher demand means less risk

Less risk means lower yields

Lower yields mean higher prices

We hope to have helped you to clarify a few of those yields queries. We also believe that you are now surely more equipped if you engage in a conversation about yields, risk & rents and price or value in property. If you still have queries and would like to master this topic, it would be good to consider attending one of our courses.

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